January 12, 2005

Social Security: Why Government Investing in Stocks Beats Personal Accounts

Even if you believe that you can shore up Social Security's future by diverting some of the trust fund into the stock market, the debate on the issue seems to be ignoring the option of skipping the personal accounts and just having the government itself invest a portion of the trust fund in equities, a far more efficient procedure and, as I'll argue, likely to expand revenues for social security far more than through individual accounts.

This is hardly a bizarre option since Clinton announced his goal of implementing this strategy in his state of the union speech in 1999 (along with personal accounts IN ADDITION to preserving the normal social security benefits.) And federal employees already invest in such a system through the Federal Thrift Savings plan and, of course, state pension funds already invest heavily in the stock market seeking greater returns.

And why is direct government investment in the stock market better than creating a system of personal accounts?

(1) Greater efficiency: Administering personal accounts that function like 401(k)s for 150 million social security beneficiars would be an administrative nightmare. The National Academy of Social Insurance - a blue ribbon style organization - had extensively analyzed the problem in this report (see analysis starting on p. 25); the problems run from coordinating and monitoring payments by employers, coordinating investment choices with individual employees, tracking all returns on investments for each worker, dealing with divorce and other contested claims on the accounts, and son on.

The bottom line: while current administrative costs for social security are just $15 per worker involved, private accounts could cost as much as $50 per year. Such a system would knock out up to thirty percent of the touted accumulated returns on investment. Worse, as R. Kent Weaver of the Brookings Institute indicates, this is especially inefficient for the many small accounts in the system:

administrative and marketing costs in decentralized individual account systems where pension funds are "retailed" to individual consumers are likely to lower eventual pensions by fifteen to thirty percent. . . Because many of the costs associated with maintaining individual accounts are fixed costs—notably record-keeping and communication with shareholders those charges are likely to hit small accounts held by persons working at low wages particularly hard...

On the other hand, the administrative costs for the government investing directly in equities is relatively minor, so the investment returns from the stock market will go to retirees, not to administrative costs.

(2) Risks are distributed through collective investments: The point of any insurance system is to distribute risk. Even if we accept that the AVERAGE returns from investments in the stock market might be better than the current system of social security investing solely in treasury bonds, in a system of individual accounts, those average returns could still yield terrible returns for some retirees, plunging them into poverty if they are unlucky in the market.

Collective government investment in the stock market means that risks are shared and everyone gains the benefits of any gain from average returns on investment, without anyone ending up on the poorhouse end of the investment bell curve.

So these are the obvious consensus reasons why many analysts argue for collective investment in the stock market over creating a costly system of personal accounts. But there's a third reason why collective investment could do far better in strengthening social security funding:

(3) Government investments could be directed to investments that strengthen wage growth: The idea that the government might actually use all this capital in the social security trust fund in a pro-active manner gives rightwing economists hives, but it makes a lot of sense. James Glassman from the American Enterprise Institute attacked Clinton's proposal to have the government invest in stocks with the S scare word:

I do not want to sound overly dramatic, but, by definition, the plan is a step toward the dictionary definition of socialism: government ownership of the means of production.

Yet even in Glassman's hyperbolic venting, he admits that the government would own only 3.7 percent of the total value of the shares on the stock market, hardly enough to implement five-year plans. The government's existing regulatory powers over business gives it far greater potential control of business operations than this tiny minority share of stock would. Even with this reality, many promoters of government investing in the stock market call for elaborate controls to require blind investments in stock indexes.

But such blind investing would eliminate one of the advantages of collective investing for strengthening the social security system. While social security investments would not give the government control of existing industrial production, the government could strategically direct those investments to companies and industries that strengthen job growth and the wage base of the american economy, which in turn would expand the payroll taxes being paid into the social security system. Such Economically Targetted Investments (ETIs) are used by state and city pensions funds to strengthen their local economies on the same principle. See here, here and here for examples of such programs in pension funds around the country.

Individual investors have no particular self-interest in directing their money to promote national wage growth. If a company is offshoring all its labor overseas, it's still rational for an individual to invest in that company if it has a 9% annual return on investment and the domestic alternative pays only an 8% return.

But it would be irrational for social security to make a similar investment decision. This isn't a political judgment but a judgment on what would lead to the best economic returns to the social security trust fund. Every investment social security makes in domestic companies or housing developments or other investments that create wage jobs will lead to additional social security payments into the trust fund on top of any conventional investment returns.

To take an example, if social security invests in a domestic investment that returns 8% of revenue in profits AND where 30% of its annual revenues go to wages for US employees, that will lead to an additional 3.72% of revenue (12.4% of that 30%) paid in social security taxes. That is a far greater economic yield for the social security fund than an offshore investment that yielded 9% profits but no additional social security taxes.

The Bottom Line: Privatizers want to talk about "returns on investment" from social security, while ignoring the fact that social insurance systems are not like regular investments. Individuals start out with a fixed amount of capital and the only returns that matter are from annual investment returns. But governments investing their capital have two sources of economic returns from those investments -- conventional returns from equity or bond markets PLUS the taxes derived from the domestic economic growth fueled by those government investments.

Given that the strength of the social security system is going to be heavily influenced by domestic growth rates over the next 75 years, to ignore the second part of that equation in developing an investment policy for social security would be completely irrational.